Pulling the plug on failed financial institutions

The legislation we supported in 2010 does create death panels. But they found them in the wrong place. The U.S. federal government now has the power to terminate the lives of large, heavily indebted financial institutions — not frail, gravely ill old people.

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Nearly five years ago, then-Treasury Secretary Hank Paulson and Fed Chairman Ben Bernanke informed the leaders of Congress, including us, that they needed hundreds of billions of taxpayer dollars to stave off a global economic meltdown. With the homes, retirements and jobs of millions of Americans at stake, we took action. But we also set out to reform our antiquated regulatory system and develop a new framework that provided regulators with the tools they needed to help prevent any future economic crisis — and end taxpayer bailouts and the concept of too big to fail.

The Dodd-Frank Act is clear: Not only is there no legal authority to use public money to keep a failing entity in business, the law forbids it.

First, it repeals the power the Federal Reserve had possessed to extend funds to any financial institution. It was this authority that the Fed used to advance $85 billion to keep American International Group alive. That power no longer exists.

Second, we recognized that the failure of a large financial institution to pay its debts could cause massive problems in the economy, as the collapse of Lehman Brothers did. And we allow federal regulators to deal with this.

But the first step they must take under the new law is to begin the process of liquidating the institution. The board of directors is abolished; the executives are fired; and the entity is put into receivership, run by the Federal Deposit Insurance Corp., which has experience putting insolvent banks out of their — and our — misery. The assets of the institution, including all the equity of the shareholders, are at the FDIC’s disposal in winding things down.

If those assets are insufficient, the FDIC’s only recourse is to draw from the Orderly Liquidation Fund the law established, which consists entirely of money raised from other large financial institutions.

Despite these explicit provisions, some critics complain that somehow, we have left too big to fail in existence. We issue them two challenges.

First, go back to the financial bailouts of 2008 and 2009, and find any such action that is possible under the new rules. Second, explain to us how public money could be used under these rules to keep a highly indebted institution alive.

We have heard two rebuttals. One, which completely ignores political reality, is that should a large bank falter, the president would come under overwhelming pressure to find some way to avoid the law’s provisions and bail it out.

Is it seriously argued that a Congress that resists the routine job of paying our past debts would somehow adopt legislation reversing the anti-bailout restrictions to save a large, indebted and very unpopular bank?

The other argument is that if several institutions were to fail simultaneously, we would be swamped, and a massive, multiple bailout would be required. Even in the crisis of 2008, it wasn’t true. Indeed, Secretary Paulson essentially had to compel several of the largest banks to accept Troubled Asset Relief Program money even though some did not need it or want it, lest the intuitions that did require help be stigmatized.

Dodd-Frank includes many more provisions to deal with institutional failure. It blocks the granting of mortgage loans with a high likelihood of default; regulates derivatives trading with requirements of margin, capital and transparency; requires securitizers of loans made by others to retain some of the risk of default; significantly increases capital requirements for these companies; and requires the large institutions whose failure might endanger stability to draw up plans to facilitate their liquidation.

We believe this combination of preventive measures — a comprehensive list that explains the bill’s length — will work to avert disaster. But no one can be sure that firms will not find other ways to get in trouble. If they do, the death panels take over, and the institutions die, with no taxpayer burial costs.

Chris Dodd is a former senator from Connecticut, and Barney Frank is a former congressman from Massachusetts.